The worst is now past, or so we hope. But what was it all about? How
can things have gone so wrong so suddenly? And what should we do to prevent
another financial crisis - or if one comes, what should we do to minimize
it?

The truth is that nobody really imagined that something like the Asian
financial crisis was possible, and even after the fact there is no consensus
about why and how it happened. Still, in the last year or so a number of
economists seem to have converged on a view about the Asian crisis that
might be described as "open economy Bernanke-Gertler". (See, in particular,
my own piece " Balance
sheets, the transfer problem, and financial crises ", and the recent
paper of Aghion, Bachetta, and Banerjee (1999)). The idea is this: suppose
that, as argued by Bernanke and Gertler (1989), investment is often wealth-constrained
- that is, because firms face limits on their leverage, the level of investment
is strongly affected by the net worth of their owners. And suppose also
that for some reason many firms have substantial debt denominated in foreign
currency. Then two nasty possibilities can emerge. First, a loss of confidence
by foreign investors can be self-justifying, because capital flight leads
to a plunge in the currency, and the balance-sheet effects of this plunge
lead to a collapse in domestic investment. Second, the normal response
to recession - namely, printing money - becomes ineffective, even counter-productive,
because loose money would reinforce the currency depreciation, and thereby
worsen the balance-sheet crunch. And hence the Asian crisis: seemingly
irrelevant events caused a self-fulfilling loss of confidence, and conventional
macroeconomic remedies were not available.

Now I doubt that anybody believes that this is the whole story; but
it is the most persuasive model of the crisis that we have. And we should
therefore take that model seriously, and ask what it implies for the future
- both for reform of the international financial architecture (of course,
the first step in such reform is to find out who is responsible for that
pompous phrase, and punish him), and for the response to crises if architecture
reform fails.

This note begins with a brief statement of a simplified "1997" crisis
model; then describes the apparent implications for policy in a crisis;
and finally considers what sort of architecture reform might prevent crises
in the first place.

1. A cartoon model of financial crisis

Ever since the 1960s, the workhorse of open-economy macroeconomics has
been the Mundell-Fleming model. In its simplest version, this model consists
of three equations. First is an aggregate demand equation relating domestic
spending to real income and the interest rate, together with net exports
that depend on the real exchange rate:

(1) y = D(y, i) + NX(eP*/P, y)

Second is a money-demand equation:

(2) M/P = L(y, i)

Finally, in the simplest version, investors are supposed to be risk-neutral
and have static expectations about the exchange rate, implying an interest-arbitrage
equation

(3) i = i*

In practice, this model is too simple for even the most basic uses;
in particular, nobody believes in static expectations about e. A
better version of (3) would have expectations that e tends to return
to some "normal" value, possibly one determined by purchasing power parity.
But let us stick with the simplest version for now.

This setup can be regarded as simultaneously determining output y
and the exchange rate
e. Figure 1
shows how this works. The vertical line AA shows all the points at which,
given (2), the domestic and foreign interest rates are equal. Meanwhile,
the line GG shows how output is determined given the exchange rate; it
is upward-sloping because depreciation increases net exports and therefore
stimulates the economy.

To turn this into a model that can yield crises, all we need to do is
add a strong open-economy Bernanke-Gertler effect. Suppose, then, that
many firms are highly leveraged, that a substantial part of their debt
is denominated in foreign currency, and that under some circumstances their
investment will be constrained by their balance sheets. Then the aggregate
demand equation will have to include a direct dependence of domestic demand
on the real exchange rate:

(1') y = D(y, i, eP*/P) + NX(eP*/P, y)

How would this dependence work? At very favorable real exchange rates,
few firms would be balance-sheet constrained; so at low eP*/P the
direct effect of the real exchange rate on aggregate demand would be minor.
At very unfavorable real exchange rates, firms with foreign-currency
debt would be unable to invest at all, and therefore the direct exchange-rate
effect on demand would be trivial at the margin. (The economy would be
like Indonesia today: the corporate sector basically bankrupt and unable
to invest, but small firms and farmers benefitting at the margin from a
weak currency). But in an intermediate range, the effect might be large
enough to outweigh the direct effect on export competitiveness, so that
over that range depreciation of the currency would be contractionary rather
than expansionary.

In short, as pointed out by Aghion et al, we might expect the GG curve
to have a backward-bending segment, as in Figure
2 ; and hence there could be multiple stable equilibria, one with a
"normal" exchange rate, one with a hyperdepreciated exchange rate and a
bankrupt corporate sector.

And we immediately have our cartoon version of an Asian-style financial
crisis. Something - a whiff of political instability, a financial crisis
in another country that investors think looks like you, or even deliberate
market manipulation by big speculators - causes a sudden large currency
depreciation; this depreciation creates havoc with balance sheets; and
the economy plunges into the crisis equilibrium.

Of course it is a highly oversimplified story, and needs a great deal
of elaboration (which will surely be forthcoming in the years to come).
But simplified and simplistic are not the same thing; arguably this story
is more sophisticated than the catchphrases and seat-of-the-pants
intuition that governed economic policy during the crisis, and still dominate
discussions of architecture reform. So let's look at what this miniature
model seems to imply for policy in the crisis and after.

2. Policy in the crisis

Suppose that, for whatever reason, your economy seems to be heading
for the crisis equilibrium. Never mind new financial architecture; right
now you live in a structure that seems to be collapsing. What do you, and
your friends at the international financial institutions, do?

In practice orthodox attempts at crisis management seem to have involved
five types of action; let me discuss each of them in turn with the model
as a backdrop.

(i) IMF financial support : The IMF, together with whatever other
sources of funds can be mobilized, provides the troubled country with a
credit line. What does this do?

The answer, basically, is that it provides the country with additional
funds to intervene in the exchange market - more dollars to support the
baht, won, whatever. Leaving aside monetary policy (treated below), this
is a sterilized intervention; so it is an attempt to use sterilized
intervention to move the exchange rate away from the crisis equilibrium.
The trouble with this policy is, of course, immediately apparent: in a
world of high and increasing capital mobility, sterilized intervention
is a tool of limited effectiveness. It can still work: capital isn't really
as mobile as it is sometimes claimed to be, foreign exchange markets in
developing countries often remain surprisingly thin, and within limits
intervention can work simply because people think it will work. But leaving
aside the psychological impact, it is hard to escape the sense that the
importance and effectiveness of credit lines to troubled economies has
been exaggerated. Calling the IMF the international lender of last resort
sounds impressive; calling it, more accurately, the "sterilized intervenor
of last resort" probably more accurately conveys the limits of what a few
billion dollars can accomplish.

(ii) Rollovers and standstills : Private creditors are gathered
together and persuaded, either by moral suasion or by the threat of unilateral
moratorium, to maintain or roll over short-term debts, credit lines, etc..

At one level this is similar to IMF lending: by inducing investors who
would otherwise have tried to convert domestic currency into dollars not
to do so, it in effect acts as a sterilized intervention on behalf of the
currency. One might argue that when a standstill is negotiated in conjunction
with a credit line, it is doubly effective, because it shuts off not only
the demand for dollars that the creditors would have created in the absence
of a program, but the additional attempt to convert local currency into
dollars that would have happened as a result of the IMF lending itself.

But creditors will object that they are being unfairly singled out:
what if they are bullied into maintaining their positions, while at the
same time other investors - say, domestic crony capitalists - flee the
currency? And they have a point. Indeed, if there is a very large pool
of mobile capital, a standstill that freezes only bank loans (or even one
that also freezes bondholders) will alter the composition of capital flight
but not its volume; the economy can still be plunged into the bad equilibrium
regardless.

How real is this concern? The truth is that in the four front-line Asian
crisis countries, and in the related speculative attack on Brazil, short-term
debt to banks was the dominant source of capital flight. Close consideration
of the day-to-day fluctuations of exchange rates in Brazil also suggests
that the foreign exchange market there remains surprisingly thin, so that
sterilized intervention can have a big effect on the exchange rate
- which means that the standstill agreement Brazil finally negotiated with
the banks did make a difference. Only in the case of Hong Kong was the
main channel of speculative attack something other than bank debt. So perhaps
the fungible-capital world in which neither IMF credit lines nor even "burden-sharing"
by private creditors makes much difference has not yet arrived. Still,
as markets get more sophisticated and integrated, that day is on its way;
in the longer run even broad burden-sharing that encompasses bondholders
as well as banks will become increasingly ineffective.

(iii) Fiscal policy : The government does something - expansionary
or contractionary - with its budget. In the early stages of the crisis
the IMF imposed fiscal austerity; currently the recovery is being partly
driven by deficit spending.

It is clear from Figure 2 that the application of fiscal austerity does
not in any objective way help prevent or cure an Asian-style crisis. After
all, fiscal contraction shifts GG to the left : if anything, this
may eliminate the "good" equilibrium and guarantee that the crisis actually
happens. Of course, if fiscal austerity creates market confidence - which
is to say that the market has some incorrect model of the situation in
which austerity is the right answer - then it could work, because when
there
are multiple equilibria belief can create its own reality. But then perhaps
one should try other confidence-inducing measures that do not objectively
push the economy in the wrong direction (advertising campaigns? public
penance by the leadership, including televised self-flagellation?)

Fiscal expansion, on the other hand, does work: it shifts GG to the
right, and if undertaken on a sufficient scale can rule out the crisis
equilibrium. The question is whether countries are able to undertake such
expansion on the needed scale. Deficit spending strengthens the yen, just
as Mundell-Fleming would predict; but it may not be a usable option for
smaller nations that are debtors rather than creditors.

(iv) Monetary policy : The principal, and much-disputed, tool
in IMF stabilizations has been a temporary sharp tightening of monetary
policy to support the exchange rate, following by gradual loosening once
confidence seems to have been restored.

Somewhat surprisingly, our cartoon model allows a rough rationale for
the "IMF recipe". Consider Figure 3, and
imagine that for some reason markets appear to have become convinced that
the economy is heading for the crisis equilibrium - a belief that, if unchecked,
will become self-fulfilling. One way to prevent this from happening is
to drastically tighten monetary policy, shifting the AA curve so far to
the left that it becomes like A'A' - that is, far enough to rule out the
crisis equilibrium. Once investors have become convinced that the exchange
rate is not going to depreciate massively, this monetary contraction can
be relaxed.

The problem, of course, is that along the way the economy faces a sharp
contraction in real output, with all the social and perhaps political disruption
that causes. Also, although I cannot capture it in this miniaturized framework,
a large real contraction can itself cause a collapse of investment, putting
the economy into a different but equally unpleasant form of low-level trap.
(See the discussion of this point in "Balance sheets, the transfer problem,
and currency crises").

You could argue, based on the Mexican and Korean experiences, that this
strategy - whenever there is a basically arbitrary loss of confidence in
an economy, impose a temporary monetary contraction and hence a severe
but hopefully short-lived real contraction - works in the end. But you
have to admit that it's a hell of a way to run a world economy.

(v) Structural reform : When the crisis occurs, the government
is urged to announce and implement major structural reforms such as privatization,
cleanup of bad banks, etc..

In the context of our cartoon model, it is hard to see why this is an
effective crisis policy. That is not to say that structural reform is a
bad thing: all of the crisis countries had (and still have) very unsound
economic systems. But if you believe that the crisis itself was mainly
a matter of self-fulfilling pessimism, it is hard to see why structural
reform should be helpful - unless, the all-purpose answer, it somehow leads
to increased confidence.

An aside: in practice, the unusual extension of IMF policy in this crisis
to embrace wider issues of economic governance probably hurt rather than
helped confidence. On one side, it fed the perception that the problems
of the crisis countries were deep and not easily resolved; on the other,
it led to struggles over implementation that reinforced the sense that
things were out of control.

If this review of the standard options for crisis management seems rather
downbeat, it should. The truth is that none of the over-the-counter remedies
seems to work very well - although it seems fairly clear that at least
for now we should be quicker to prescribe debt standstills and rollovers
rather than depending entirely on confidence-building gestures.

What could be done? Well, the obvious answer - you knew this was coming!
- is to rule out the bad equilibrium by force majeure, imposing
capital controls as a temporary emergency measure during a crisis. Conceptually,
this should be viewed as a logical extension of the case for agreements
to roll over short-term debt: it simply involves concerted action by a
larger class of investors. The main objections to temporary capital controls
ought to be practical - the claim that they will disrupt ordinary commerce,
or inevitably lead to irresponsible policies on the part of the imposing
government. For what it is worth, Malaysia's experience suggests that the
practical difficulties are not as large as widely claimed. And the absence
of large capital flight when the controls were loosened does indicate that
controls can be successfully advertised as temporary measures, and
removed when the risk of self-fulfilling pessimism has abated.

An analytical approach to the crisis suggests, then, that when the next
crisis comes we ought to try from the start to impose some kind of curfew
on capital flight. Perhaps this need only take the form of debt rescheduling
for now; but the possibility of more comprehensive controls should not
be ruled out.

Of course, the best answer would be not to get into a crisis in the
first place. What might prevent future crises?

3. Architecture and all that

I don't know who came up with the term "international financial architecture".
Aside from the perhaps inevitable pompousness, the trouble with this phrase
is that it suggests a deliberate, controlled structure that simply does
not exist in a world of fluid capital markets and very limited official
control. The Bretton Woods system - which basically assumed a world in
which private capital movements were of limited significance, and in which
the key question was one of setting the rules of the game for government-to-government
lending - could be regarded as a piece of "architecture". Whatever system
or non-system we now impose will be at best a set of guidelines on policy
between crises.

Let me put on one side the apple-pie-and-motherhood stuff about transparency,
and focus on the two real areas of dispute: what should be done with the
exchange rate regime, and what should be done about capital flows.

The exchange rate regime: An odd aspect of the aftermath of the
crisis is that some people emerged from it convinced that fixed exchange
rates were the villain, and that a floating regime could prevent future
crises; while other people found it a compelling demonstration of the importance
of strongly fixed regimes, such as currency boards, or even dollarization.
The funny thing is that our cartoon model helps suggest why both sides
might be right.

The case for a currency board, or even dollarization, can be made by
considering whether the IMF recipe of temporary tight money would really
be necessary if the exchange rate were completely credible. Suppose that
everyone knows that a government will not, under any circumstances, allow
the kind of currency depreciation that would lead to a circular process
of depreciation and balance-sheet collapse. Then the market will not come
to expect the depreciation in the first place, and the crisis will not
get started. A truly credible commitment to a fixed exchange rate, in other
words, can prevent Asian-type financial crises. And this is true a fortiori
of the ultimate version of such a commitment, which is not to have a national
currency at all.

The problem, of course, is that there are other risks in the world besides
Asian-type crises - garden-variety recessions, massive bank failures, and
so on. And a currency board or dollarized system leaves a country with
reduced ability to respond to such risks. It would be wrong to make too
much of Argentina's current recession; these things happen now and then.
But the recession surely does remind us that, contrary to the claims of
their enthusiasts, currency boards do not exempt their owners from the
ills to which economies that have renounced stabilization policy are prone.

What about floating exchange rates? The main claim of those who advocate
them as an "architectural" measure, as opposed to a useful tool of macroeconomic
policy, is that the exchange regime itself affects the composition of debt.
When a country has a more or less fixed exchange rate, the story goes,
companies are going to be tempted to go for the lower interest rates they
can get by borrowing in dollars or yen; in so doing they create the backward-bending
segment of GG that is key to the possibility of crisis. By having a floating
exchange rate, then, a country can discourage foreign-currency-denominated
debt, and thereby make itself less vulnerable.

To a trained economist this view immediately sounds fishy: if there
is a risk of future devaluation, why are domestic borrowers so willing
to take on foreign-currency debt. But maybe there is some exchange rate
illusion involved; certainly it is true that countries with quasi-fixed
rates have tended to have more dollar debt than those without.

The final question here is why be so indirect about it. If foreign currency
debt is a problem, why not discourage it directly rather than depending
on exchange volatility to do the job?

Capital flows: In the light of the cartoon model, four sorts
of proposals not normally regarded as similar can be seen as conceptually
very related. These are proposals to enhance the ability of the IMF (or
perhaps other institutions) to offer credit lines to threatened countries;
Feldstein-type proposals for "self-protection" via maintenance of large
foreign exchange reserves; proposals for some presumption of private sector
involvement, aka burden-sharing, in periods of difficulty; and proposals
for Chilean-style restrictions on short-term borrowing. The reason these
are all conceptually similar is that they all are, in effect, proposals
to undertake sterilized intervention to support the exchange rate when
a crisis of confidence is threatened.

This is obvious for the first two policies. Liquidity provided in a
crunch, whether via loans from abroad or from the country's own reserves,
allows intervention in the exchange market; unless this is also part of
a monetary contraction, it is sterilized intervention. But as I pointed
out earlier, getting foreign creditors to maintain their short-term loans
is also in effect a form of sterilized intervention; and providing incentives
for domestic firms not to take on short-term debt in the first place is
a more indirect way of doing the same thing.

Will such measures work? It depends, again, on what you think about
the effectiveness of sterilized intervention. My general view is that the
integration of world capital markets is a bit less dramatic than widely
believed, and that sterilized intervention therefore does make a difference.
But much though not all such intervention will be offset by other kinds
of capital flows, meaning that all of these proposals will (if they are
implemented at all) prove disappointing to their proponents - and as capital
markets become more sophisticated, they will become ever less effective.

What would work? I have already suggested a possible answer: if the
key to the risk of crisis is foreign-currency-denominated debt, then concerned
countries should tax or otherwise discourage such debt (as opposed to simply
hoping that a floating exchange rate will have the same effect). The point,
again, is to eliminate the backward-bending segment of GG, and hence the
danger of self-fulfilling financial crisis.

But let me not try too hard to resolve the question of financial architecture
reform; it is not exactly a burning issue right now, since it seems very
unlikely that anything important will actually happen until the next crisis
rolls around. The main point of this analytical note is to suggest a way
of thinking about the crisis past - and to argue that policy recommendations
for crises future ought to flow from our best analytical shot, not from
ideological preconceptions.